Updated on: April 14 2021 ; Wealth & Value
Here we come again:
We have already talked in great detail about compounding in early articles. The power of compounding never fails to amaze me. It is so simple and yet so powerful.
So I thought, why not revisit this topic.
This time, I have decided to present a few examples showcasing how would compounding work, and how would be it impact your investments.
Basic premise:
The basic premise here is that the investor has an investment horizon of 30 years. Yes, you read it right – 30 years. The power of compounding only become clearly evident after a very long time.
The ideal case would be when an investor invests regularly throughout the time period of 30 years.
But here, I want to focus on the benefits of starting early. We will see, how an “early start” coupled with the power of compounding can do miracles.
So I have broken down the 30 years investment time period into two sections. The first section is for 10 years and the second section is for the following 20 years.
We will see the difference in the returns for different cases when investments are done in different time sections. In the cases that we will study below, the investor either invests in the first time section or the second time section. We have deliberately taken the second time section to be twice as much as the first time section giving him/her some advantage.
The investor invests 10,000 rupees at the beginning of each investment year. I am calling it an investment year because the investor invests either in the first 10 years or the next 20 years.
We have assumed that the investment vehicles gives a return of 9% annually.
Case descriptions:
We have simulated six different scenarios and are calling them cases. Following are a brief description of these cases.
Case 1: The investor invests 10,000 rupees annually at the beginning of each year for the first 10 years. The investments are stopped from the 11th year onwards. The amount invested stays as-is for the next 20 years.
Case 2: There are no investments in the first 10 years. 11th year onwards, the investor starts investing 10,000 rupees annually at the beginning of each year for the next 20 years.
Case 3: Like case 1, the investor invests 10,000 rupees annually at the beginning of each year for the first 10 years. But from the 11th year onwards, the investor starts withdrawing 5,000 rupees annually for the next 20 years.
In the three cases discussed so far, the invested amount is fixed throughout the time period. In the next three cases, we will increase the investment amount by 5% annually.
Case 4: The investor starts with the annual investment of 10,000 rupees in the first year. He/She then increments the investment amount by 5% over the previous year’s investment amount (compounded). This incremental investment continues for 10 years. The investments are stopped from the 11th year onwards. The amount invested stays as-is for the next 20 years.
Case 5: There are no investments in the first 10 years. The investor then invests 10,000 rupees at the beginning of the 11th year. He/She then increments the investment amount by 5% over the previous year’s investment amount (compounded). This incremental investment continues for the next 20 years.
Case 6: Like case 5, there are no investments in the first 10 years. But the starting investment amount in the 11th year is not 10,000 rupees. It is the amount that would be equivalent to the investment in the 11th year in case 4, had the investor continued with his/her investments. That would be 16,289. The investor then increments the investment amount by 5% over the previous year’s investment amount (compounded). This incremental investment continues for the next 20 years.
Case analysis:
These six cases cover a wide range of variations. They will help you witness the real power of compounding in action.
In cases 1, 3 and 4, the investments start early. Whereas, in cases 2, 5 and 6, the investments start late, and the investment duration is also twice as much as the former cases.
I think, we now have a good grip on the different cases. So, let’s see what the final investment values look like at the end of 30 long years.
First, let’s compare the two basic cases, case 1 and case 2. Despite investing half the amount in case 1, the returns are ~1.6 times higher than that of case 2. This is not what one would expect normally. But, thanks to an early start clubbed with the power of compounding, this is possible.
Now let’s bring in the next case – case 3. Here, the investor not only stops investing from the 11th year but also starts withdrawing money from the corpus. The annual withdrawal amount is half the amount of the annual investments made earlier. These withdrawals continue for double the number of investment years, making the net investment amount zero at the end of 30 years.
This might come as a surprise to some. But even with withdrawals, the returns for case 3 are 16% more than case 2. Such is the power of compounding.
Similar results can be seen for cases 4, 5 and 6, where the investment amount increases every year. You will notice the difference in the Growth Factor (Final Investment Value / Net Amount Invested) between case 4 and the other two cases.
Conclusion:
An early start is more important than the amount invested. If you can start early with a smaller sum, the magic of compounding will power up its value over time. This value increases exponentially with time, which might be not noticeable in the beginning, but gets quite significant over time.
So don’t bother waiting till you accumulate a large enough sum to start your investments. Start with whatever you can. You can always top up your investments as you go along. As they say – Time once lost never comes back unless you are the genius with the time machine locked up in the garage. The same is true with compounding, as it flies on the fuel called time.
Obviously, you have to be careful with where you are putting in your money. For the different investment vehicles please do check out the previous articles and keep coming back for newer ones.
Start early !!!